Structured Credit Products

Credit Derivatives and Synthetic Securitisation

Moorad Choudhry

• Publisher: Wiley
• Year: 2011
• Print ISBN: 9780470824139
• eBook ISBN: 9781118177136
• Edition: 2
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

Updated coverage of structured credit products with in-depth coverage of the latest developments

Structured credit products are one of today's fastest growing investment and risk management mechanisms, and a focus of innovation and creativity in the capital markets. The building blocks of these products are credit derivatives, which are among the most widely used products in finance. This book offers a succinct and focused description of the main credit derivative instruments, as well as the more complex products such as synthetic collateralized debt obligations. This new edition features updated case studies from Europe and Asia, the latest developments in synthetic structures, the impact of the subprime meltdown, along with models and teaching aids.

Moorad Choudhry returns with this excellent update of the credit derivatives market. The second edition of his classic work is, like the subject matter itself, at the forefront of the financial industry. It deserves a wide readership.
— Dr Didier Joannas
Regional Director, Thomson Reuters, Hong Kong

This is the perfect companion for both experienced and entry level professionals working in the structured credit fraternity. It is an erudite, insightful and enjoyable read that successfully demystifies one of the most topical subject areas in banking today, while also providing important practical examples that link the theory to the job itself.
— Dr James Berriman
Global Pricing Unit, Royal Bank of Scotland

Moorad Choudhry has earned a deserved reputation from both academics and practitioners as one of the leading practical yet rigorous authors of finance books. In this Second Edition, his practical knowledge of credit derivatives keeps the audience engaged with straightforward explanations of complicated structures, and an accessible level of mathematical sophistication necessary to understand structured credit products. The author offers complete, rigorous analysis while avoiding overuse of mathematical formulas and carefully balanced practical and theoretical aspects of the subject. I strongly recommend this book for those wishing to gain an intuitive understanding of structured credit products, from practitioners to students of finance!
— Mohamoud Barre Dualeh
Senior Product Developer, Abu Dhabi Commercial Bank, UAE

This is THE book for credit derivative trading. From first steps to advanced trading strategies, this is invaluable. Well written and insightful, perfect for ad hoc reference or reading cover to cover.
— Andrew Benson
ETF Market Making, KBC Peel Hunt, London

Professor Choudhry has inspired me to really get into credit derivatives. It's great to be lectured by someone with such energy and practical hands-on experience, as well as the ability to get stuck into the details.
— George Whicheloe
Equity-Linked Technology, Merrill Lynch, London

Moorad Choudhry is Head of Treasury at Europe Arab Bank plc in London. He is a Visiting Professor at the Department of Economics at London Metropolitan University.

PART I

Credit Risk and Credit Derivative Instruments

Credit risk is the risk of loss arising from the inability of a borrower to make interest and/or principal repayments on a loan. Anyone who has lent funds to a borrower that is not considered as default risk-free is exposed to a certain level of credit risk. While credit risk has been a factor for investor concern ever since the development of capital markets, it has received considerable attention among market participants since the 1990s. This attention has taken the form of ever more sophisticated methods of measuring credit risk and managing credit risk. It is the latter that is the backdrop to the instruments discussed in this book. An understanding of the former is necessary, therefore we will begin with a look at credit risk and credit risk measurement.

Credit derivatives are important tools that are used in the managing and hedging of credit risk, and also for trading and investing in credit, as we shall see. All credit derivatives are instruments, financial contracts in fact, that enable credit risk on a particular named asset or borrowing entity, the reference entity, to be transferred from one party to another. In essence, one party is buying protection on the reference entity from the counterparty, who is selling credit protection. The buyer pays a premium to the seller during the life of the credit derivative contract in return for receiving credit protection. The seller agrees to pay the buyer a pre-specified amount under certain conditions of default, or upon a restructuring event.

We begin with a look at credit risk and risk measurement. After our introduction to the concept of credit risk, we look in detail at all the important credit derivative instruments, their description, application and pricing. The main instruments are credit default swaps, total return swaps and credit-linked notes. Although all these instruments achieve the same end-goal of transferring credit risk exposure from a protection buyer to a protection seller, there are subtle differences between them. Credit-linked notes are fundamentally different to the other two types, as they are funded credit derivatives as opposed to unfunded ones. We explain this shortly. An instrument developed much earlier, the asset swap, is nowadays considered to be a credit derivative as well, so we also look at this product.

THE CONCEPT OF SYNTHETIC INVESTMENT

If one stops to consider it, banks have been ‘selling protection’ on their customers ever since they began formally borrowing and lending in the Italian city-states during the Middle Ages. Let’s think about it.

Cash Investment

A Bank lends 100 florins to Mr Borrower for a period of five years, who agrees to pay interest of C% per year each year until loan expiry, at which point he will return the original 100 florins. This is shown at Figure 1. We assume that Mr Borrower does not default on payment of both interest and principal. The net gain to Bank after the five years is the interest of C each year, which after five years will be 5C. (We have ignored funding costs here.)

Synthetic Investment

A Bank sells protection on Mr Borrower to Mr Practitioner for a period of five years, who agrees to pay C basis points premium per year each year until trade expiry. This is also shown at Figure 1. We assume that Mr Borrower does not go into bankruptcy, liquidation or administration during the five years, and that Mr Practitioner keeps up the premium payments until expiry.

FIGURE 1 Cash and synthetic investment: no default.

The net gain to Bank after the five years is the CDS premium of C each year, which after five years will be 5C. Note that Mr Borrower is not involved in this transaction at all, as we see in Figure 1. It is between Bank and Mr Practitioner.

This illustration is a bit cheeky but it makes the point. The return for Bank of 5C is identical in each case. So Bank can decide between cash and synthetic investment; in theory the return will be identical. In terms of net cash flow, the end-result actually is identical if the price associated with Mr Borrower’s credit risk is C. The only difference is that the cash trade is funded while the CDS trade is unfunded. Bank has to find 100 florins to lend to Mr Borrower, but doesn’t need to find any cash to invest in Mr Borrower via Mr Practitioner.

Of course, if there is a credit event, then Bank will have to find 100 florins. So we need to consider the event of default. Before we do, let’s make it a bit more real . . .

Real-world Application

If we convert the bond investment to an asset swap that pays LIBOR + X basis points (bps), the interest basis of the bond has changed from fixed coupon to floating coupon. It is now conceptually identical to the synthetic (credit default swap) premium of X bps.

In the cash market, we assume that the investor has funding cost of LIBOR-flat, so that the 100 it borrows to buy the bond with costs it LIBOR-flat in funding. The net return to the investor is X. For the synthetic investor, who has no funding cost (it does not borrow any cash as it is not buying a bond), the net return is X bps.

Let us now allow for a default or ‘credit event’.

Cash Investment

At the beginning of year 3, Mr Borrower is declared bankrupt and defaults on his debt to Bank. The Bank falls in line with the other creditors, and after three years receives a payout from the administrators of 39 cents on the florin.

After five years, Bank has therefore received 2C in interest, but lost 61 florins of capital, a substantial loss.

Synthetic Investment

At the beginning of year 3, Mr Borrower is declared bankrupt and immediately Bank pays 100 florins to Mr Practitioner. In return, Mr Practitioner delivers to Bank 100 florins nominal of a loan that Mr Borrower took out from A N Other Bank. This loan has some residual value to Bank, at the time it is valued at 30 cents on the florin so Bank records a capital loss of 70 florins, a substantial loss.

After three years the Mr Borrower loan that Bank is holding is valued at 39 cents on the florin, so Bank recovers 9 florins of the loss it booked three years ago. Hence, after five years Bank has received 2C in interest, but lost 61 florins of capital, a substantial loss. The illustrations are shown in Figure 2 above.

FIGURE 2 Cash and synthetic investment: default.

The point we are making is that funded and unfunded investments are identical on a net-net basis, in theory anyway, and involve taking credit risk exposure in Mr Borrower’s name. The price of this risk is C%, and reflects what the market thinks of the credit quality of Mr Borrower. Of course there are some technical differences, not least the introduction of another counterparty, Mr Practitioner. But from the point of view of Bank, both trades are in essence identical; or at least have identical objectives. And the synthetic trade actually has some advantages for the investor, principally with regard to the fact that no funding is required. The counterparty risk to Mr Practitioner (principally his ability to keep up premium payments) can be viewed as a disadvantage, although there are ways to mitigate this.

CHAPTER 1

Credit Risk

Credit risk emerged as a significant risk management issue during the 1990s. In increasingly competitive markets, banks and securities houses began taking on greater credit risk from this period onwards. W...

Table of contents

• Cover
• Contents
• Title
• Copyright
• Dedication
• Foreword
• Preface
• Acknowledgements
• About the Author
• Prologue: The 2007–2008 Credit and Liquidity Crunch: Impact on Structured Credit Markets
• Part I: Credit Risk and Credit Derivative Instruments
• Part II: Structured Credit Products and Synthetic Securitisation
• Part III: CD-R
• Contributing authors
• Afterword: Econometrics, finance and football . . .
• Glossary
• Index